Double-edged sword

There is some irony in the fact that, just as Europe seems to be reaching a barrier to further integration, there have been reports about a major step in the economic integration between two South Asian countries""India and Sri Lanka""by way of a common currency.

This level of integration was achieved by Europe in the late 1990s and, in the debates leading up to the national referendums on the European Constitution, did not appear to be a major source of disquiet.

However, after the French vote rejecting the Constitution, demands have been voiced in Italy for a return to their original currency, the lira.

It is quite possible that in evaluating the costs and benefits of further integration, some elements within the European Union (EU) are re-visiting their experiences with what has already happened.

In doing this, the adoption of a common currency is surely one issue that will induce some soul-searching.

Contemporary notions of a common currency that straddles national boundaries stem from the work of Nobel Laureate Robert Mundell, who challenged the view that a currency and a country went hand in hand.

He argued that the degree of economic integration within a region""the freedom of movement of goods and services, capital and labour""was what justified a common currency and, by consequence, a common monetary authority.

In theory, the EU fulfils those conditions, having gone through successive increases in the freedom of movement within the union.

Even as it was in the early stages, where free internal trade was being pursued, member countries engaged in an exchange rate co-ordination mechanism to minimise the impact of exchange rate uncertainty on trade.

The euro was an institutionalisation of that arrangement, but by ceding monetary control to the European Central Bank, members surrendered whatever monetary autonomy the co-ordination mechanism had allowed them to exercise.

This is where the problem lies. The EU today is a relatively heterogeneous collection of members in terms of levels of affluence, demographics, competitiveness, and, very importantly, domestic regulations, specifically those pertaining to labour markets.

As a consequence of varying domestic regulations, labour mobility within the union is not as free as appears on paper. Unemployed resources in one country cannot easily move to where jobs might be.

However, the hands of member countries to use macro-economic instruments to deal with domestic unemployment are effectively tied by virtue of the fiscal deficit ceilings and the fact that the European Central Bank makes monetary policy.

This leads to the basic question: given the reality of Europe today, is a common currency optimal from all members' viewpoints?

If Sri Lanka were to accept the Indian rupee (either formally or through a hard peg), it would be making a similar compromise. Its monetary policy would be run out of Mint Road.

If it believes that increasing economic integration with India is inevitable, this may not be such a bad thing for it. However, if it is looking beyond South Asia for trade and investment flows, retaining autonomy may be the wiser course.